COLUMN-Why IPOs are unlikely to produce long-term gains

Reuters

By John Wasik

CHICAGO, Nov. 4 (Reuters) - As the founders and backers ofTwitter move toward the ultimate tweet - an initialpublic offering - it's a good time to ask whether IPOs are goodinvestments.

Can the hot social media buzz surrounding Twitter besustained for the company to survive a flame-out? While few canaccurately predict future earnings growth, management decisionsand whether the service can grow and gain more popularity, it'sgood to cast a cautious eye on IPOs in general and cast a widernet.

Keep in mind that Main Street and Wall Street investors mayhave entirely different takes on IPOs. Short-term traders may"flip" the stock after a few days - or even hours - and thenmove on. Individual investors may be gun-shy about owning IPOsafter last year's botched offering of Facebook. It took ayear for investors to recover from the company's initial pricedecline.

If you like small- or micro-cap companies for their growthpotential, it would make sense to own a passive index of them.The iShares Micro-Cap ETF, for example, tracks theRussell Microcap Index, charging 0.72 percent for annualexpenses. The fund is up nearly 37 percent for the year throughNov. 1 and holds companies like Methode Electronics,Multimedia Games Holding and Boulder Brands,.

For a much-broader based fund that holds small companiesthroughout the world, consider the SPDR S&P InternationalSmall-Cap ETF, which has gained 22 percent for the yearthrough Nov. 1. The fund charges 0.59 percent for annualexpenses and holds companies like Belimo Holding AG,,Shochiku Co and Rubis.

As with IPOs in general, although small-cap ETFs spread outthe risk among hundreds of stocks, they are still much morevolatile than their large-cap brethren. A fund like the iSharesMicrocap, for example, carries of five-year standard deviation -a measure of volatility - of 23, compared with 16 for the S&Pindex.

LONG-TERM RECORD TROUBLING

How well you can do with an IPO depends upon how long youhold it. The timing involved in selling it, though, can benettlesome.

Over the short term, when investor excitement is high andthe general investment climate stable, IPOs can produce somestartling initial gains. When Netscape, one of the firstInternet browser companies, went public in 1995, the offeringprice was $28. The stock soared to $174 by the end of that year.

But as the competition dug in, Netscape's market sharecratered from 80 percent to less than 10 percent. By 2008, thecompany, long since absorbed by AOL, was pretty muchkaput as a serious browser business. Countless IPOs havefollowed the same course, so it's wise to avoid wagering a bigstake on an offering and instead choose a broad-basket index ofsmall stocks.

What makes an IPO successful - at least in the short-term -is widespread optimism throughout the market and in the sectorthe stock represents. Internet stocks went gangbusters up untilthe dot-com bust of 2001. Are social media stocks headed for thesame fate?

"IPOs can be a good investment, but usually they don't workout long-term relative to the market," says David Zuckerman, acertified financial planner in Los Angeles. "I typically try topersuade my clients not to buy them."

It helps to look at the sectors of the stocks being offeredthis year and try to gauge their long-haul appeal. Overall, it'sbeen a strong year for IPOs, with 111 companies going public inthe second and third quarters and another 11 going to market inthe last quarter, according to Hoover's IPO Scorecard.

In the fourth quarter, biotech companies will dominate, witheight companies accounting for 14 percent of total offerings,followed by six software companies, comprising about 11 percentof the total offerings. The average value of fourth-quarterofferings is nearly $400 million, compared with $228 million forthe second quarter.

One concern is that this latest wave of IPOs may be feedingoff a bubble mentality - that is, the enthusiasm for new stocksmay be over-valuing them. But when you look at price-to-bookratios, measures of a stock's market price to book value, maybethose fears are overblown.

The technology sector, for example, has a negative 15price-to-book ratio. That compares with 45 for the overallhealthcare sector, which has been popular this year with theintroduction of the Affordable Care Act exchanges.

A low price-to-book ratio could indicate that a stock orsector is undervalued relative to the rest of the market.Although the price-to-book ratio is not a perfect measure ofrelative values, it may indicate that biotech stocks may beoverpriced and tech stocks are a bargain.

There's even more risk in concentrating in one stock. It'snearly impossible to predict the course of stock prices ingeneral; it's even more difficult to forecast the future of justone company, no matter how bird-like its appeal.

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